Ratio Analysis

1. Ratios are used to remove the “size” effect from

comparisons – sometimes ill-advisedly.
2. To illustrate, use the
Stock (or Inventory) Turnover Ratio =
Cost of Sales/Average Stock Held.
as a measure of (operating?) efficiency.
3. Benchmarking this ratio implies that Average
Stock held should increase in direct proportion to
activity volume (COS).
4. But economies of scale suggest that, as activity
increases, av. stock level should not increase at
same rate (EOQ theory) whilst JIT policy aims for
zero stock.
5. Moral – we need to use information on both ratios
and absolute figures to evaluate performance.
 Common Size Statements
1. The most straightforward form of ratio analysis
is using “common size statements”. In this, all
items are shown as a percentage of (generally)
the largest item – e.g. make Revenue = 100 in
Income Statement, or Total Assets = 100 in
Balance Sheet and show everything else as
percentage of these.
2. Often, these are sufficient to show significant
trends and to identify unexpected structural
changes .
One payoff from ratio analysis, as this implies,
is that it can trigger more interesting questions.
 Common Size Statements
Income Statements Balance Sheets
2006 2007 2006 2007
Sales Revenue 100 100 Fixed Assets 85 87
Cost of Sales 55 53 Current Assets 15 13
Gross Profit 45 47 Total Assets 100 100
Expenses 34 34 Shareholders Equity 37 39
Operating Profit 11 13 Non Current Liabilities 42 41
Interest 5 3 Current Liabilities 21 20
Profit before Tax 6 10 Total Financing 100 100
Tax 3 1
Profit after Tax/
Net Profit 3 9
 Ratio Analysis - Uses
• Time series analysis
• Cross sectional comparisons
• Benchmarking
• Prediction
• Risk analysis
• Valuation
• Decision making – investment?
• Accountability
 Types of Ratios
• Activity/Efficiency – Turnover, no. of days
e.g. Debtors/Receivables Turnover Ratio
• Short term risk/Liquidity
e.g. Current Ratio
• Longer term risk/financial structure
e.g. Debt to Equity Ratio
• Profitability and Margins
e.g. Return on Assets, Gross Sales Margin
• Market based
e.g. Price Earnings Ratio
 Activity/Efficiency Ratios
• Turnover ratio = Measure of activity (e.g. Sales) / average balance
(e.g. Average Debtors)
• Average days held* = 365 / Turnover Ratio
(e.g. DTR = 12 means Av period credit given = 30.4 days)
Type Activity Balance
STR COS Stock or Inventory (includes wip)
DTR Sales Debtors or Receivables
CTR Purchases/COS Creditors or Payables
ATR Sales Assets
WCTR Sales Working Capital

(*can use to calculate length of operating cycle: stock > wip > debtors >
cash > -creditors)
 Short term risk/Liquidity ratios
• Current Ratio = Current assets/Current liabilities.
• Quick ratio or Acid test =
(CA-Inventory)/Current liabilities
• Cash ratio = (Cash + Marketable securities)/
current liabilities
• Cash flow from operations ratio = CFO/
current liabilities
(also Defensive Interval and Cash Burn Ratios)
Longer term risk/Financial structure
(gearing or leverage) ratios
• Financial risk v. operating risk
Ex: Firm with 50% debt. (Net) interest cost = 4%. ROA of
16% gives ROE of 28%.
But ROA of 2% gives ROE of zero.
I.e. ROE is more volatile with more debt, given volatility
of ROA. Total risk = operating risk + financial risk.
• Possible gearing or leverage measures:
• Debt/Equity Ratio
• Debt/Total Capital
• Interest cover

• Market or book values?

 Margins and Profitability Ratios
• Margins: Gross Profit/Sales
• Net Profit/Sales (etc.)
• Profitability (ROI) = measure of profit/
measure of capital or assets
• e.g.: ROA = EBIT/Total assets
• ROTC = EBIT/(Debt + Equity)
• ROE = Net Income/Equity
• Note that all BS figures should be averages, in
theory.
 Market Based Ratios
• These are not, strictly speaking, drawn from the
financial reports, since they may involve market
data such as share prices.
• Examples are: Price-Earnings (PE) Ratio;
Earnings per Share (EPS); Earnings Yield;
Dividend Yield; Dividend per Share; Payout
Ratio; and Price to Book Value Ratio (Tobin’s Q,
if Book Value = Replacement Cost).
• All of these have been used as “active” valuation
aids, particularly for unquoted companies and in
merger/acquisition situations.
 Inter-relationships
• ROA = Asset Turnover (Sales/Assets)
x x
Return on Sales (Profit/Sales)

• Patterns of success (or failure) – strategies?

• Diagnostic use of ratios.

• Importance of using all information.

 Pyramid of Ratios
ROI
ROE
Gearing

Markup Asset Turnover

Fixed AT Current AT WCTR

STR CTR
DTR Cash TR
Expenses/Sales
 Limitations of Ratio Analysis
1. Garbage in > Garbage out:
outdated, incomplete, irrelevant
information?
2. Non-comparability (accounting policies)?
3. Lack of theoretical support.
4. Creative and aggressive reporting.
5. Need context (qualitative analysis).
6. Combining ratios (weighting), negative numbers.
 Dupont Decomposition of Ratios
(ref: White et al, pp. 142/143)

• ROE = Net income/Av. Equity =

• Operating margin = EBIT/Sales X
• (1-Interest burden) = Pretax income/EBIT
[% of EBIT not paid to debt holders] X
• (1-Tax burden)=Net income/Pretax income
[1 – t] X
• Asset Turnover = Sales/Av. Assets X
• (1 + Leverage) = Av. Assets/Av. Equity
[(E + D)/E]